Gold-plated pension liabilities – what next for law firms?

The demise of top US firm Dewey & Leboeuf, reportedly due to its lucrative bonus schemes and costly mergers, may not have direct parallels to the current state of affairs in the Scottish legal sector, but a growing number of firms are facing mounting problems with historical pension schemes.

The legacy of such schemes, whether single employer final salary or multi-employer schemes, has already seen extensive reform. Put simply, the costs of such schemes have for many become too great, a fact that has become increasingly evident across both public and private sectors.

More often than not, the pensions liability of law firms will arise from one of two different sources. Commonly, these stem from a commitment by current partners to pay a pension for life to retiring partners. Payments will be of a fixed amount or on an increasing basis, which allows for annual pension increases. Where such arrangements are in place, the schemes are only sustainable where profitability is maintained at or above existing levels. However, in today’s economic climate, with some firms struggling to maintain profitability, such liabilities may become increasingly difficult to service.

Another scenario is where a firm has contributed to a final salary occupational pension scheme for staff, where the liabilities have not been bought out in full. This could arise through the partnership having its own single employer final salary scheme or an industry wide scheme.

The latter is a well known scenario for numerous smaller Scottish law firms, as they count the cost of their original involvement in the Scottish Solicitor Staff Pension Scheme.

Partner liabilities

Fundamental changes have been made to pensions regulation in the last decade. Back in the 1970s and 80s, in an environment with sparse regulation, attractive investment returns, and the cost of purchasing annuities still offering sensible value, firms commonly made a commitment to participate in industry schemes or sponsor their own. The implementation of the Pensions Act 1995 and, in particular, s 75 which requires employers to make good the deficit on an annuity buyout basis in certain circumstances, has led to a change in attitudes among employers.

For some firms the situation may be serious, as they struggle to fulfil their pension obligations. In these circumstances, what are the options available to those facing such liabilities?

Where a partnership is dissolved, a s 75 debt will be triggered. This could arise through retirement of partners and the lack of willingness to find a successor to take over a practice burdened by a heavy commitment towards the final salary pension scheme. An annuity buyout deficit is also triggered where an employer decides to wind up the scheme. In certain circumstances, this may also be the outcome where the trustees have such powers.

As a result of triggering an annuity buyout, long-retired partners may be held liable for debts some 10 or even 20 years after retirement, because the law firm has subsequently dissolved. It can be very difficult finding new equity partners to put money into a business knowing the partnership has a very significant financial commitment towards a historic deficit in its final salary staff pension scheme. Equally seriously, such issues will discourage banks from lending money to the business.

The Pensions Regulator has recognised the potential challenges around this issue and laid down guidance on scheme abandonment. This is aimed at preventing partners from simply winding up the partnership and setting up a new one the next day, without being pursued by the Pensions Regulator to make up the deficit in the former partnership’s pension scheme.

Current options

However, it is possible to address these issues before it becomes too late. Employers have the option to de-risk the pension scheme to reduce the liability. This may be achieved through an enhanced transfer exercise or pension increase exchange. Pensioners may alternatively be given the option to take an annuity, at a lower level than the full annuity buyout cost, or purchase an impaired life annuity, instead of receiving standard benefits under the scheme rules, where an individual has a limited life expectancy.

A pension increase exchange exercise is one where pensioners in receipt of pension are offered a one-off increase in respect of non-statutory future increases. Crucially, no further increases will be available following such an agreement.

This process allows employers and trustees to gain a greater degree of control over future scheme risks. It is a strategy already used effectively by several schemes, which could see scheme members offered an immediate uplift in their pension, sometimes around 20%, with no further increase for the rest of their lives. While this may be attractive to pensioners with low life expectancy, it is clearly less attractive to those pensioners with high life expectancy. The aim of the employer is to profit from taking the risk out of members living a long time and, therefore, paying cumulative increases.

Another option, which has created some public controversy, is a de-risking strategy where pensioners are offered the option to take an annuity but at a lower level than the full annuity buyout cost. While not for everyone, pensioners in poor health would get a greater sum of money in the short term, during their limited life, compared with an offer of a five-year guarantee of pension benefit under the rules of the scheme.

Guidance to follow

The Pensions Regulator is set to change its guidance on enhanced transfer value strategies and, possibly, pension increase exchange exercises. The future options available to employers and trustees may, therefore, be set to change. Currently, it is possible to enhance the transfer value to pay the top-up in cash, with the transfer value simply being the reduced amount the trustees believe the funding of the scheme can withstand. There is a high degree of uncertainty as to whether such cash payment options will survive the next Pensions Regulator’s guidance, which could see the removal of the cash option in the coming months.